US economy shrinks, but dip seen temporary

The US economy contracted at a 0.1 per cent rate in the fourth quarter last year, as Washington slashed defense spending and businesses trimmed inventories ahead of the feared fiscal cliff, Commerce Department data showed Wednesday.

Governments at all levels tightened the reins in the October-December period, forcing the slowdown. But the effort was unexpectedly sharp at the federal level, with a 22 per cent reduction in defense outlays ahead of the programmed "sequester" cuts originally set to hit from January 1.

The sequester, a $US110 billion forced spending pullback, half of it in defense, still looms at the end of March if political leaders cannot craft another less austere program for deficit reduction.

But the avoidance of the sharp tax hikes of the fiscal cliff before the January 1 deadline could help with a rebound this quarter, especially from business investment, according to analysts.

The Commerce Department said that despite the dismal fourth quarter, the economy expanded overall, growing a modest 2.2 per cent for the full year 2012, a pickup from 1.8 per cent in 2011.

The fourth quarter estimate, the government's first although it is often revised later, was lower than forecast. But it came after a strong 3.1 per cent pace in the third quarter.

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"The downturn in real GDP in the fourth quarter primarily reflected downturns in private inventory investment, in federal government spending, in exports, and in state and local government spending," the department said.

It stressed that the first estimate of GDP growth is based on incomplete data and is often revised.

The largest factor in the contraction was a 6.6 reduction in spending by government authorities at the federal, state and local level, with the federal government reducing expenditures by 15 per cent.

The core of that drop was a 22 per cent drop in defense spending. The Defense Department still faces an automatic $US55 billion budget reduction for 2013 due to the programmed sequester cuts.

Democrats and Republicans remain locked in debate over what kind of deficit reduction program should be implemented to replace the sequester, with little concrete progress reported toward a compromise.

Economists downplayed the contraction in light of other strong signs in the economy.

Despite the looming cliff -- which could have meant a sharp tax increase for all Americans -- consumer spending climbed from the third quarter, as did business investment in equipment and software, and investment in housing.

But businesses pulled back investment in inventories, and the employment record shows they were cautious about hiring during the period.

"The slight decline was the first since the recession in 2009, although it almost certainly overstates weakness significantly after what was exaggerated strength in Q3," said Jim O'Sullivan, chief US economist at High Frequency Economics.

"It would be a mistake to view this drop in GDP -- driven by temporary corrections in defense spending and inventories -- as a possible harbinger of recession," said economists Nigel Gault at IHS Global Insight.

"The incoming data points to continued growth, and we expect GDP growth to rebound to around two per cent in the first quarter."

The contraction was a surprise, admitted economist Harm Bandholz of UniCredit.

US markets were largely unaffected by the data, with the main indices bouncing back and forth before trading slightly lower in early afternoon.

The dollar, was sharply lower, with the euro buying $US1.3574. But most of its loss came before the data release.

The GDP data came as the Federal Reserve was holding its first policy meeting of the year, with a fresh monetary policy statement due out in the afternoon.

O'Sullivan pointed out that current data shows little inflationary pressure, so that, with unemployment still high, the Fed is under no pressure to tighten its $US85 billion a month quantitative easing "QE" bond-buying program.

"We still expect the signal from the Fed today will be full-speed-ahead on QE3," he said.